Managers-Net

Value Based Management

Value Based Management

By providing a consistent strategic focus, Value-Based Management is a tool to enhance the techniques through which corporate value is improved.

Every day, people at all organizational levels make decisions that affect their company's value - yet
the link between these decisions and change in company value is often not made.
Without this link, how can companies be sure the decisions being made are increasing value - the single most
important measure of a company's success?
Value-Based Management can foster this link by providing three things:

A philosophy that puts value creation at the centre of operational decision-making.

A process that links day-to-day management with strategic objectives.

A measure of business performance that overcomes the deficiencies of traditional accounting
and of perfomance measurement.

Corporate value is created when the returns on investments are greater than the cost of the capital
required to make the investments. The trick is ensuring that everything that is done in the
organization adds value to it, and galvanizes everyone to work towards the over-riding aim of
growing long-term shareholder value.

What are the classic methods used to measure company value?

Like beauty, value tends to be in the eye of the beholder. You can't
exactly appraise any business until you answer two questions: Value to
whom and for what purpose? That being said, there are four generally
accepted methods of valuation. Each is a correct way of establishing
value, and whichever method is used will depend on the particular
circumstances, and whether the valuation is being made by a seller or a
buyer.

Book value

which is simply the value of the company's net assets.

Current value

which reflects net assets plus the underlying company performance, assuming
constant market share.
Current value includes a current market premium on the book value.

Intrinsic value

which reflects the current asset base assuming best in class productivity and
constant market share. There is often a value gap between a company's actual share price and
what corporate management believes is the real value of the business.
This gap is the difference between intrinsic value and current value.

And how can Value-Based Management be used as a tool to improve corporate value?

The first, Shareholder Value looks at the long-term cash flows generated by an organisation's
business units and discounts them back to today's value at the cost of capital. This is also known as
free cash flow.

The second, Shareholder Value Added is principally concerned with ensuring that the return from
the assets in which management has invested is greater than the cost of the funds invested. This is
logical, since management is expected to invest funds in assets and projects that meet shareholder
expectations. So while SV delivers a long-term strategic perspective that relates to share value,
SVA helps the decision-making process at the level of individual projects and investments. It drives
short and medium-term management behaviour - essentially functioning as a day-today management
tool to provide a focus for operational improvement aligned with investment decisions.
So, Value Based Management can be viewed as an approach to improving SVA as a management tool.

How exactly should one understand the term "value added"?

To use a simple example, if someone borrows £1,000 from a bank for one year at an interest rate of
10% ( the cost of capital ), £100 in interest will be paid. If the capital is invested in a business that
makes a profit of £150, that return is 15% of the capital. The value added is £50, £150 profit less
the interest of £100, or 5% of capital.
So it is important to differentiate between return on investment and value added.

But a business has to make more money with the amount it has borrowed than the cost of borrowing it.
This is because shareholders will expect a premium on the return compared with a safer
investment such as government bonds.
So applying the criterion that a prudent investor would use is
a much tougher measure of the real performance of a business than profit alone.

The cost of capital reflects the interest paid on debt plus the return expected by shareholders,
which will include a premium for the risk of providing equity.
In the value calculation, the cost of
capital is introduced to remind managers of the commitment to provide returns to all the different
sources of capital and to reflect the mix of capital used.
Most important here is how Shareholder Value Added can provide a simple measure that guides day-to-day
decision-making at every level in the business.
Such decisions might include:

Whether to invest capital, based on potential earnings being greater than the cost of capital.

Identifying where reducing costs and waste will have the greatest impact on value.

Identifying profitable products and customers on which to focus growth.

Whether to divest assets not earning the cost of capital.

In the past, capital has been seen as a scarce resource. SVA shows that capital is plentiful, but expensive.

What are the operational factors which typically drive value?

Increasing value involves managing those factors in a business that influence value.
We term these factors value drivers.
For example, increasing operating margins without affecting sales volumes will increase value, so operating margins is a value driver.
There are seven value drivers that apply in all organizations and we call these generic value drivers. They are:

Value and price, (the revenue drivers, where volume is derived either from growth in the market or growth in market share).

Operating margins

Tax ( using different tax jurisdictions to advantage )

Fixed assets

Working capital

Cost of capital

The length of time a company maintains a competitive advantage against competitors.

Doing things differently in a business will usually affect more than one value driver.
For example, a price increase might affect volume and working capital and maybe fixed assets as well.
Management must assess the relationship between value drivers, which will be different for different businesses.
It's possible to model the effect on value of changes to the value drivers, and thereby help identify the best
courses of action to increase corporate value.

So carefully analysing each of the company's value drivers should point to the optimal allocation of resources?

Yes, the resource allocation, capital budgeting and portfolio management processes are the means
by which capital and other resources, including people, are focused on those opportunities that
offer the greatest potential to increase value.

In principle this means that capital is invested in those parts of the business that will generate
returns in excess of the cost of capital, and withheld from those parts that will fail to exceed the
hurdle rate. The test of value-added provides a vital focus on product, customer and business unit profitability.
This is a crucial stimulus to improve the business, by acting either to encourage
profitable growth, or to stop value erosion caused by unprofitable relationships with customers and unprofitable products.

So although capital should no longer be seen as a scarce resource, other resources become the
constraint on what is possible. In most organizations the true resource constraints are people and
their capabilities (or lack of them), and time.
A company must be able to identify unprofitable products, customers or business units so that it can
either find ways of making them profitable, or invest the resources elsewhere.

There must be methods independent of capital allocation to improve value, such as simply working smarter.

Capital should be invested when it is clear that increased operating profits will more than cover the
charge for additional capital. However, there are several other ways of enhancing value, either to
improve operating profits without using additional capital, or to reduce capital where operating
profits give an inadequate return.
One of line management's primary tasks should be to ensure that business processes are operating at
lowest cost and that customers are serviced effectively.
Improving efficiency and effectiveness reduces operating expenses, improving stock turns reduces work-in-progress
and better arrangements for creditors and debtors reduce financing costs, and so on.

A business that has not successfully re-engineered its core business processes and supporting
activities usually offers major opportunities to cut waste, reduce cycle times, increase productivity
and improve customer service. Improvements on the order of 20 percent or more are common.

The process of value creation involves taking a long-term view, managing all aspects of cash flow,
and understanding how to compare cash flows from different time periods on a risk-adjusted basis.
Value-Based Management enables executives to consider all the competing claims for resources such
as processes, customers, suppliers, employees, shareholders and so on. The proper balance of
resources results in the least waste and the greatest value for shareholders.
Using these techniques, I would view long-term value enhancement in the range of 20 percent as realistic.

How can VBM be embedded in a company's capabilities and culture?

VBM must be embedded into the normal ways of the business. Above all this is a cultural issue in
which two factors are critically important. The first is performance measurement and associated
reward mechanisms, and the second is education and communication. The purpose of performance
measurement is to focus managers on achieving business objectives. The old adage "what gets
measured, gets done" means that the wrong measures are certain to get the wrong things done.

Establishing and communicating the link between increasing SVA and the remuneration received by
individuals - or preferably, teams - ensures that people will be keen to know how they can
positively influence value. Systems of incentive and reward have a powerful effect on collective and
individual behaviours. For example, a sales force targeted and rewarded on revenue alone will
inevitably have scant regard for profitability, or departmental measures of cost control may restrain
expenditure at the expense of process effectiveness and customer service.

Value-Based Management provides a common goal and framework for an organisation's performance
measurement system. It requires a total process perspective, and therefore ensures as far as
possible that people and departments have compatible goals, and that co-operation and teamwork
are built into the structure of performance measurement and reward.

What training and management development methods are necessary when introducing VBM?

Value-Based Management challenges much accepted wisdom. Not least it raises questions about
conventional ideas of accountability. Conventional cost center-based budgeting, management
accounting and financial reporting strongly encourage the notion of individual accountability.
The reality is that in any organization there are few accountabilities that are not shared, and value
creation is above all a shared accountability.

People need a good understanding of what is meant by value, and how it is created.
This often means "unlearning" much of the existing body of knowledge, ideas, assumptions and attitudes
that underpin the organisation's ways of working and decision-making.
Managers must develop a common understanding of value creation, use a common language and share a common commitment to implementation.
Education and good communication are crucial to shared understanding and commitment.

What potential pitfalls should management be on the lookout for?

Introducing Value-Based Management has all the potential pitfalls of any change initiative. I'd say ones of special importance are:

Involve everyone, not letting VBM become something only for the accountants.

Avoid complexity, while ensuring that simplicity does not risk misunderstanding.